Private equity with Chinese characteristics

Elsewhere, I intend to reflect on my pet theme that China is reinventing – and indeed single-handedly resurrecting – equity as an asset class. In my opinion, this reflects an underlying self-confidence and correlates with the emergence of other equity cultures such as the Netherlands in the 18th century, England / Britain in the 19th and America in the 20th century, in contrast to the contemporary Japans, Koreas and Taiwans of this world.

In the meantime, developments in Chinese private equity are also worth noting. For a start, when we talk about private equity in Asia ex-Japan, we are effectively talking about just one country: the PE market in Greater China reached US$222bn in 2016, whereas SE Asia combined only managed US$37bn. The ASEAN region has not yet emerged as a market of material scale.

However the prevailing orthodoxies of PE in China are also showing that the market will not come to simply resemble OECD behavior. As many observers will know, Chinese funds operate in a grey area between classic private equity and venture capital, and sometimes throw in an element of special situations or even hedge funds to boot. This comes through in the types of deals that are done – whereas conventional buyouts still account for almost 80% of the N American market, in China this is just 20%. Instead, growth capital and PIPEs account for a much larger chunk, itself revealing that PE funds typically take smaller stakes in Chinese targets and rarely buy the whole company.

Asian private equity deals by type (2012 – 2016)

PE by type

Source: AVCJ and Prequin via Bain Asia Pacific Private Equity Report 2017

Why is this? There are a number of reasons which play a part:

  1. Stage of development – the simple point that in a high growth market, sellers may be younger and in any case desire to have a greater piece of the future upside that a company might yet deliver. It also means that there is less appetite for use of debt in the transaction.
  2. Exit liquidity – by far the biggest problem PE funds have had in emerging markets is a clear pathway to exit. Recent turmoil in the Chinese stock markets for instance cause a lower risk appetite for funds, who may find it easier to sell a stake than to shepherd the company to IPO.
  3. Control issues – perhaps the most important matter, PE funds do not always have the confidence to take a company over completely since they will be susceptible to the vagaries of China country risk. A partner of some sort often seems necessary to keep a company functioning the way it has been historically.
  4. LP involvement – this leads neatly to the preponderance of strategic investors who exist in the market, and who it is better to work with than against. LP involvement in deals stands at 29% in APAC and an enormous 57% of deals over US$1bn, compared to a global average of just 17%.

LP involvement in transactions

LP involvement

Source: Bain Asia Pacific Private Equity Report 2017

So where does all this leave us? In my mind, there are a range of different players in the Chinese PE market, and they fulfill a range of roles. On the one hand, there are the classic international players, but often these are not capable of realistically doing a deal on their own without some sort of local partner angle. On the other end of the scale, you have the very Chinese funds who retain many of the classic characteristics of Chinese business ambiguity in their dealings – at times almost seemingly linked to the state. In between you have the good stuff – the international firms who have really localized and look and smell like Chinese funds; and the few local funds who have really made an effort to westernize in their business practices, if not their focus.

Here, purely subjectively based on my own experience, is an overview of the landscape of funds in and around China:

Chinese PE.png

This will cause many an argument, I am sure. But I have tried think about ways of reflecting the degree of “localisation” too. The best I could come up with involving an excel spreadsheet was to analyse where these funds were keeping their staff – the more onshore, the more localised they might be supposed. The results were interesting if not conclusive:

PE by office.png

Source: company websites

Warburg Pincus and Blackstone represent good counterpoints. Warburg is by common consensus one of the most successful foreign funds in China, and its staffing reflects this since more than half of the Asia employees are based in Beijing and Shanghai. This reflects the 26 Greater China deals they have done against the 4 in ASEAN. Blackstone on the other hand, prefer to hub-and-spoke out of Hong Kong (a business model which has had its day, as I have written before). Their deal count is correspondingly lower. It need not be added that sheer numbers of staff can help, but only if they are the right staff in the right places.

The lesson of all this is simple: China will be a very large, profitable private equity market, but it will do so on its own terms. As with much else, assuming that China will develop along the lines of its OECD counterparts is a recipe for disaster. Whilst it has some of the framework for creating a functioning market, the behavior will be totally different. Foreign participants will have a role, but they will have to adapt. This will be, as Deng Xiaoping said, private equity “with Chinese characteristics”; but perhaps we can also add, it does not matter if it is a local cat or a foreign cat, as long as it catches deals?

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